Is the IMF incompetent or...

In this new market billions can flow in or out of an economy in seconds. So powerful has this force of money become that some observers now see the hot-money set becoming a sort of shadow world government - one that is irretrievably eroding the concept of the sovereign powers of a nation state - Business Week

The importance of finance in a globalised world cannot be underestimated. Movement of global capital (and not any other factor of production) from one country to the other has often been held by economists to be the last mile connectivity of a country in its process of globalisation.

In fact for the past few decades no other factor of production - labour or for that matter technology - has invited as much attention and discussion at the global level as the movement of finance has. It may not be out of place to mention that having realised the potency of this arrangement, developed countries, notably the US have lost interest in the Doha Round of trade negotiations under the aegis of the WTO. Why produce, trade, take risks and complicate issues when one can profit merely through movement of finance?

Put pithily, one who controls finance controls the world of trade, commerce and business.

Evolution of global financial architectureThe manner in which the world of finance dominates the global economy, its disproportionate influence, its extraordinary power in shaping and de-shaping the global economy and yet to remain un-critiqued is one of the most perplexing aspects of modern life.

To understand the DNA of this architecture a reference to the developments since World War II which led to the formation of the World Bank and the IMF is inevitable. Under this arrangement (also called as the Breton Wood arrangement) each participating government guaranteed to exchange its own currency on demand for US Dollars at a fixed rate. The underlying argument that led to this arrangement was that stability of exchange rates was crucial for development of global economy.

In turn, the US Government guaranteed to exchange dollars on demand gold at a rate of at a rate of $35 per ounce of gold. This effectively placed all the currencies on indirect gold standard, backed by the US gold reserves. Governments thus came to accept US dollars as gold deposit certificates and held the USD as a global currency.

But this arrangement was based on a fundamental premise that the US economy would always remain strong enough to support its dollar. But the cost of the Vietnam War considerably weakened the faith of the rest of the world in the dollar as the de facto global currency. This situation had the potential that could have led to a run on the USD with countries and investors surrendering the excess dollar and asking for gold in return.

To pre-empt such a danger the then US President, Richard Nixon, removed the convertibility of the dollar to gold in August 1971. This completely dynamited the very structure of global finance conceived by Breton Woods meet. But in the process the world had inevitably got hooked to the dollar as the global currency by virtue of the rules adopted earlier.

The fixed exchange rate of the Breton Woods system of the post World War II was replaced by a floating exchange rate mechanism. With the result the global financial architecture of post 1971 was a virtual anti-thesis when compared to that of pre 1971. Crucially, what was sought to be avoided by creating the IMF was legitimised through the IMF itself!

Dollar as a commodityThus begins the dangerous dollar game. It requires some further understanding of this game to more fully appreciate the global financial architecture as it operates today. After the currencies were floated against one another with no single reference point, the US began to manipulate the new financial floating exchange architecture to ensure that surplus dollars, which had accumulated in the hands of other countries, were brought under its control.

Thus was born the petrodollars phenomenon. By using its political clout with the OPEC, (the global oil cartel) the US persuaded it to carry out a steep increase the prices of Crude. It may be noted that even today as against the estimated cost of production of a barrel of crude at less than $15 in Saudi Arabia, the international selling price is well in excess of $115. This huge profit made from selling oil to you and me virtually runs the US economy.

This sucked the excess USD circulating globally into the hands of a handful of oil producing and exporting countries. The dollars thus sucked by the OPEC countries could not be invested anywhere except the US, as no other country could absorb such gargantuan investment. So these petrodollars are invested back into the US economy by OPEC members as long-term investments, at times less than even one per cent per annum. It is these investments that continue to fuel the growth of US.

In effect, the explicit gold standard of pre 1971 had given arise to an implicit crude standard of the seventies. And this was further expanded to include the entire global trade and multi-commodity regime since the eighties. But the Dollar game does not stop here.

Virtual finance and digital economicsThe floating exchange rate mechanism of post 1971, particularly with an unprecedented expansion of various financial instruments, mechanisms and structured products, had the net effect of giving arise to what is colourfully termed by experts as "virtual finance." And then with the proliferation of technology, this arrangement itself morphed into digital economics overwhelming the real or actual economics.

What is crucial to note here is that the sheer size of the virtual financial market viz., the world of virtual finance and digital economics, outnumbers the real economic transactions by approximately over 100 times. This would give the reader the extent of the mind-boggling influence of the virtual finance over the actual in sheer size.

This subsequently expanded into an elaborate network of derivatives market - estimated to be in excess of $500 trillions when compared to the global GDP of approximately only USD 50 trillions and global trade of goods and services not exceeding $10 trillions - which at present is beyond the power of any regulator or monitoring mechanism.

Naturally, this led to a complete disconnect between the global financial system and the global production mechanism. In the process the production sector has been completely marginalized by this global financial order. It may be noted that global trade heavily depends on this financial system, which in turn by its very unstable nature causes currency instability and derails the global economy, trade and commerce. What a messy situation!

In short, when currencies become commodities and begin to be traded on virtual basis, with complete disconnect to the real economy, the consequences are indeed disastrous.

IMF's surveillance programmeCrucially, all these arrangements had the active blessings of the IMF through a well-documented agenda. In fact, the IMF constantly encouraged countries to enter into this game of speculation, virtual finance and of course digital economy. In fact, this has been the agenda of the IMF since the eighties. It is thus no wonder that since then the IMF has been fixated on this system while simultaneously ensuring that there are no systemic risks its flow.

Readers may note that this monitoring is carried out by the IMF through a defined surveillance programme � a mandate that was given to oversee the international monetary system, assess the economic and financial developments across continents and advise on risks to global financial stability as well as to suggest appropriate policy adjustments.

Yet, despite this overwhelming concern for finance, it is indeed bewildering to note that the entire global financial architecture is increasingly coming under extraordinary stress. In fact, some experts opine that it has already reached the breaking point as recent events in the US economy and financial markets demonstrate. Further, the recent gyrations witnessed in the commodities, currency and stock markets at the global level are all products of systemic failures and bad surveillance.

The element of surprise is not merely on the size of the crisis, which in my opinion is secondary. What is galling to note here is that such serious systemic flaws have crept in undetected for over couple of years despite multilateral supervision and surveillance.

It is in this connection it is indeed perplexing to note that the IMF - the high priest of supervision of global finance has expressed surprise - yes surprise - on the latest crisis that has engulfed the world of finance, its extent and the consequent implications.

Has the IMF merely winked at these negative developments and proliferation of financial instruments because of the some external pressure or does it not have the appropriate competency to carry out the surveillance of the global financial architecture? Is it a classical case of misplaced trust or is it a part of a deliberate design to be incompetent? Is IMF incompetent or designed to be incompetent?

They no longer use bullets and ropes. They use the World Bank and the IMF -Jesse Jackson

The seeds of the present consternation in the global financial architecture can be traced to its very design and evolution since the seventies when the post World War II Breton Woods arrangement was given up. That led to the collapse of the fixed exchange rate mechanism and gave rise to the flexible exchange rate mechanism. All these and its consequent impact were briefly explained in the first part to this series.

It may not be out of place to mention that the IMF repeatedly pontificated on the virtues of financial sector liberalisation and its calculated effect of rewarding the productive and the prudent while ruthlessly punishing the unproductive and the profligate. Unsuspecting countries, which approached the IMF for financial assistance under the structural adjustment programme, were persuaded to liberalise their financial sector.

Given such enormous stakes it was therefore of extreme importance to monitor the global financial architecture, capturing the risks to the movement of global capital as well as the risks arising of the sudden reversals in the flow of global capital. And the entire global financial architecture has been constantly monitored and certified by the IMF giving rise to the collective belief that all is well in the world of finance. But as events turn out we all now know that it has been a case of misplaced trust.

The GFS report The IMF presents a biannual report titled the Global Financial Stability Report (GSFR) as a part of its surveillance programme. Yet, in its latest GSFR report released by the IMF in April 2008, it points out that the events of the past six months have demonstrated the "fragility of the global financial system" and raised "fundamental questions about the effectiveness of the response by institutions."

What is indeed appalling to note here is that the IMF suggests that the global financial system seems to have come under increasing strain since "October 2007." The key and recurrent themes that are captured in this report include:

There was a "collective failure" to appreciate the extent of leverage taken on by a wide range of institutions.

There was a "supervisory failure" to comprehend the evolving risks through appropriate risk management systems, update disclosure norms and improve financial sector supervision so as to meet the rapid innovations and shifts in business models

There was a failure to detect the transfer of risks off balance sheets by banks. Consequently, as risks have materialized, it has placed enormous pressures back on the balance sheets of banks.

Naturally, this lack of appropriate supervision and risk management, according to the IMF, encouraged extreme leveraging. And as deterioration of the credit quality "exacerbated the de-leveraging process," the global financial system is increasingly coming under extraordinary strain.

Resilience? Gathered Strength? De-risked? Strange as it may seem, especially with the benefit of hindsight, one can safely state that the IMF has been completely oblivious to the negative developments in the global financial architecture since the past couple of years. Quite the contrary, the IMF has been virtually certifying all the developments as positive.

In fact the April 2006 GSFR states "The positive assessment contained in the September 2005 GFSR that the global financial system has yet again gathered strength and resilience has been validated by recent developments."

It does not stop there. It further states "In particular, the emergence of numerous, and often very large, institutional investors and the rapid growth of credit risk transfer instruments have enabled banks to manage their credit risk more actively and to outsource the warehousing of credit risk to a diverse range of investors. A wider dispersion of credit risk has "de-risked" the banking sector."

And wherever it has mentioned the potential risks arising from the lending to sub-prime borrowers or for that matter any other risks, it remained muted and suppressed - akin to the statutory health warning on cigarette packets. And as events in 2008 turn out and given the positive language of assurance contained in the GSFR 2006 report, one is certain that global economic surveillance of the IMF has indeed misled the world of finance.

But this is not an exception. In the past decade the world has been witness to the six major financial crisis � the East Asian crisis, the collapse of LTCM, the Russian crisis, the Argentinean crisis, Dotcom bubble and of course the latest sub-prime crisis of the US. And on every occasion the IMF simply failed to identify the crisis well on hand.

In retrospect it is clear that there was a failure on part of the IMF in identifying these risks even as they were manifesting. And now innocently terming the extant crisis as "collective failure" points out to something more than it meets the eye.

But why?The crucial question that arises from all these is a simple one - Is the IMF incompetent to monitor or is it a case of incompetence compounded by a conspiracy.

It is in this connection one is constrained to quote Joseph Stigtitz. Writing the preface to his celebrated book - Globalisation and its discontents - he states, "There are no smoking guns here. You won't find hard evidence of a terrible conspiracy by Wall Street and the IMF to take over the world. I don't believe such a conspiracy exists." Yet he goes on to add, "The truth is subtler. Often it's a tone of a voice, or a meeting behind closed doors, or a memo that determines the outcome of discussions."

Who are those who by their very tone of a voice or in such other methods as explained by Stiglitz are able to decide the future turn of events. And to understand the same, a reference once again to the US financial system and the power of its corporate is inevitable.

It is common sense that there would be very little opportunity for speculative profit in a stable financial market. The greater the volatility of financial markets, the greater opportunity it is for the players in these markets. This view was accepted by George Soros himself in a testimony to the Banking committee of the US House of Representatives in early nineties.

The riskier and more destabilising forms of modern investments are through the new instruments � popularly called the Hedge Funds managed by Soros, Goldman Sachs, Merrill Lynch et all. This process has turned investment banks into highly leveraged machines that trade heavily on their own accounts leveraging investor money several times over.

It is not merely a question of leverage that is central to the discussion on hand. The potency of these firms and the disproportionate clout that they wield on the financial markets is central to the issue on hand. And it is these players in the US financial markets that dominate the global financial architecture.

For instance, a recent article in The Economist, quotes a study of BCA Research, a Canadian economic-research firm that traces the rise of the American financial sector. The total corporate profits, the report points out, grew from 10 per cent in the early 1980s to 40 per cent last year and its share of stock market value grew from 6 per cent to 19 per cent. It may be further noted that financial services account for only for 15 per cent of corporate America's GDP and a mere 5 per cent of private-sector jobs.

This clearly illustrates the disproportionate influence of the financial sector on the US economy and its continued interest in ensuring the continuance of the global financial architecture � one that allows gyrations, volatility and of course in the process provides significant opportunities to these players to make profits, even at the cost of taking the entire global economy to the very brink.

To amplify, should the US financial system collapse; it is the developing countries that would lose heavily. After all, developing countries have lent approximately USD 3 trillions to the US. Remember, the US is too big for the world to risk a collapse. And in such a scenario, it is the rest of the world that would rush to protect the US and its Dollar. Needless to emphasise, in case of profits, the beneficiaries would be these few fund managers. Globalising losses and privatising profits! And it is this system that as the sanction nay blessing of the IMF.

Given this paradigm, to assume that IMF would act independently would be churlish to say the least. Naturally, the IMF having designed the global financial architecture is loath to write a word against its apparent systemic failures. It cannot even critique or for that matter even review it. And should it do anything that would remotely destabilise the system, it could at-once close the flow of funds from the developing countries to the US. Powerful vested interests - the beneficiaries of this system, it can be logically concluded, would ensure its continued silence.

Globalisation requires global systems and global governance. In the absence of a global government, multilateral arrangement has been worked out a substitute by all nations. But experiences of the past decade now tell us that this unaccountable and unsure system is untrustworthy, unworkable and hence unacceptable.

That explains the continued diffusion of the IMF while global financial architecture swings from one crisis to another. Till date, the debate on IMF has primarily been on its incompetence. Time has come to evaluate the conspiracy angle far seriously.